The Rebound in Stock Prices and Inflation Expectations

The stock market is up sharply and inflation expectations have been stable in the low-2% range. That’s just what the monetary doctors have been prescribing and the markets have complied. This is the sweet spot that looked unlikely last spring. But a lot can happen when a determined central bank sticks to its plan for quantitative easing. The year ahead, however, will bring a new set of challenges. The first question: How long should the Fed let inflation expectations rise?

Consider how the numbers stack up so far. The S&P 500 has been rising persistently for the past year. Inflation expectations have only recently turned higher, although it’s still early to worry about pricing pressures. For now, higher is still better. Indeed, the Fed’s preferred measure of inflation—core personal consumption expenditures—is rising at a muted 1.1% year-over-year rate through November, or well below the Fed’s 2% target. But the market’s outlook for inflation (the yield spread between nominal 10-year Note and its inflation-indexed counterpart) is increasing again, touching 2.31% in yesterday’s trading. That’s still within the range we’ve seen in recent years and so there’s nothing particularly troubling here. But if the economy is set to accelerate in 2014 (as it seems to be), we may see inflation expectations climb higher in the weeks ahead.

At what point will rising inflation expectations become worrisome? The answer, of course, depends on a number of factors, starting with the state of the economy. Meantime, the recent high for inflation expectations is roughly 2.6%. If and when the market prices the 10-year Treasury market above that level, the calculus for deciding the implications of higher inflation will be ripe for an attitude adjustment.